Legal Perspectives

08/14/2017

Nevada Governor Brian Sandoval recently signed Assembly Bill 276 (“AB 276”), which articulates new rules and requirements for non-compete agreements, some of which fundamentally alter the legal landscape for the enforcement of covenants not to compete. Most notable among the new law's requirements is the mandate that courts mustrevise language that might otherwise render non-competes unenforceable. The new law should provide comfort to franchisors operating in Nevada by closing a significant loophole left open last year by the state's Supreme Court.

New Requirements for a Non-Compete Agreement to be Enforceable

According to the new law, to be enforceable a covenant not to compete must:

Be supported by valuable consideration (the grant of a franchise or license will almost certainly be sufficient);

Not impose any restraint that is greater than necessary for the protection of the party for whose benefit the restraint is imposed;

Not impose any undue hardship on the restricted party; and

Impose restrictions that are appropriate in relation to the valuable consideration supporting the non-compete covenant.

Confidentiality and Non-Disclosure Agreements

The new law does not prohibit agreements to protect a party’s confidential and trade secret information if the agreement is supported by valuable consideration and is otherwise reasonable in scope and duration.

Courts are now Required to “Blue Pencil” Non-Compete Language that is Overbroad

This is by far the most significant part of the new law and the aspect that should give franchisors with Nevada-based franchisees the most comfort. But first, a bit of background.

Generally speaking, courts across the country have adopted one of three approaches when addressing over-broad restrictive covenants; these approaches are generally referred to with some variation of the term "blue penciling." When a court faces a non-compete that it finds objectionable based on some aspect of the provision, a court may use one of these approaches:

The court may reject the restrictive covenant in its entirety. In other words, because some aspect of the covenant goes too far in its restrictions, the court may refuse to enforce the covenant at all. This is known as “no blue penciling”.

The court may strike (delete) the parts of the covenant that it believes are overbroad, and leave the rest of the terms of the covenant unchanged. This is known as “strict blue penciling."

The court may choose to revise (rewrite) the restriction to make it reasonable. This is known as "general blue penciling" or "red penciling."

Prior to AB 276 becoming law, Nevada courts used the most conservative of all of these approaches. The Nevada Supreme Court held in the case Golden Road Motor Inn, Inc. v. Islam, 376 P.3d 151, 153 (2016) ("Golden Road") that Nevada law prohibited any form of blue penciling whatsoever, which meant that any part of a covenant not to compete the court determined objectionable would require the court to refuse to enforce the non-compete in its entirety.

Now, however, so long as a non-compete is supported by valuable consideration, Nevada’s courts are obligated to revise overbroad restrictions that impose a greater restraint than is necessary to protect the enforcing party’s interests and impose an undue hardship on the restricted party. The revisions must cause the limitations (e.g. time, geographical area, and scope of activity to be restrained) to be reasonable and no greater than necessary to protect the interest of the enforcing party. Stated differently, a Nevada court must now generally blue pencil (or red pencil) a covenant not to compete that the court believes is overbroad.

Bottom Line

AB 276 is a big victory both for employers and franchisors, which no longer need to worry about a court completely refusing to enforce a non-compete in the state. Agreements that may have been found to be void under Golden Road can now be revised and enforced in Nevada. As a result, franchisors can now enter the Nevada market with confidence, assured that courts in the state will not refuse to enforce the covenants not to compete that are commonly contained in franchise agreements.

- Special thanks to my employment law partner, Rob Rosenthal, who prepared a summary of the new law upon which this article was based (which also served as a first draft for this piece).

03/08/2016

Today I attended the International Franchise Association's fourth annual California Franchising Day. During the course of the day, I had the opportunity to meet with Assembly Members (or their representatives) Hadley, Bigelow, Brough, Miller, Baker, and Gipson, and Senator Nguyen. My group talked with them about the many issues facing franchisees and franchisors in California, including concerns about rising minimum wages, high workers' compensation premiums, and other regulatory issues facing industry members in California.

We also talked to the Assembly members and Senator about Assembly Bills 1782 and 2637, and specifically about how those bills (if passed) will improve franchising and franchise regulations in California. I found all of the Assembly Members and Senators to be very receptive to the two pending bills and the reasons behind them, and willing to listen regarding the other issues that face members of the franchise industry in California.

I remain hopeful that ABs 1782 and 2637 will find support in the legislature, and that they will not be opposed by any major interest groups as they move forward. As promised, I will keep you posted on the progress of those bills here.

03/07/2016

The International Franchise Association's (IFA) fourth annual California "Franchising Day" is set for March 8, 2016. The goal of Franchising Day is to inform California legislators about some of the key issues affecting the franchise industry. This year, the IFA's Franchising Day will "feature meetings with legislators and staff, allowing members of the franchise community to meet directly with lawmakers to discuss the benefits of franchising in California, as well as the legislative issues facing their businesses."

There are currently two key franchising bills in California. One, California Assembly Bill 1782, seeks to create a new exemption to the California Franchise Investment Law relating to franchise trade shows in the state. If enacted, this new law would permit franchisors and prospective franchisors to exhibit at franchise trade shows in California without having to first apply for a full franchise registration with the Department of Business Oversight.

The second pending bill is Assembly Bill 2637, which is designed to improve the state's law on negotiated franchise sales. As described in my previous posts here and here, the law -- intended to help California franchisees to give them an advantage during negotiations with their franchisors -- actually hurts franchisees in the state because many franchisors would rather refuse to negotiate completely than comply with the law, which franchisors view as burdensome. AB 2637 seeks to improve this situation by permitted franchisors and franchisees to freely negotiate with one another for so long as the franchisor meets certain simple disclosure and recordkeeping requirements.

Forward Franchising will be following these new bills and developments, and will keep you posted on them here.

08/27/2015

Last night I reviewed a franchise agreement and found a surprising, and illegal, provision buried deep in the contract. If ever there was a compelling case for being careful when you are choosing legal counsel, I just found the provision that makes it.

But first, some background. My law practice involves representing both franchisors and prospective franchisees. For franchisors, I primarily draft franchise disclosure documents (“FDDs”) and franchise agreements; I assist my clients in obtaining franchise state registrations; and I assist them with day-to-day issues that arise in running their businesses. For prospective franchisees, I will review their proposed franchise agreements and FDDs and help them understand what they will be committing to do if they decide to buy the franchise. If the franchise company is willing to negotiate, I help prospective franchisees through that process.

I find that reviewing other companies’ FDDs and franchise agreements also helps me in my practice for franchisors; it’s always instructive to see what other industry leaders are doing. I have noticed that, in a small minority of systems, some franchisors go well beyond what is legally permitted to be included in the franchise agreement and include provisions that unquestionably violate the FTC Franchise Rule (the “Franchise Rule”) as well as various state franchise laws.

The Provision

If you’re on either side of the franchise relationship, you should know if your contract has a provision like this one. Pull out your franchise agreement now. Go ahead, I’ll wait.

You have it now? Good. Here’s the provision we’re looking for:

Release of Prior Claims. By executing this Franchise Agreement, Franchisee, and each successor of Franchisee under this Franchise Agreement forever releases and discharges Franchisor and its Affiliates, Its designees, franchise sales brokers, if any, or other agents, and their respective officers, directors. representatives, employees and agents, from any and all claims of any kind, in law or In equity, which may exist as of the date of this Franchise Agreement relating to, in connection with, or arising under this Franchise Agreement or any other agreement between the parties, or relating In any other way to the conduct of Franchisor, its Affiliates, its designees, franchise sales brokers, if any, or other agents, and their respective officers, directors, representatives, employees and agents prior to the date of this Franchise Agreement, including any and all claims, whether presently known or unknown, suspected or unsuspected, arising under the franchise, business opportunity, securities, antitrust or other laws of the United States, any stale or locality.

In plain English: “you, the franchisee acknowledge that we, the franchisor, may have lied to you and might be lying to you right now. Our entire FDD might be one of the greatest works of fiction since Moby Dick. You agree, however, that you waive all your legal rights to take action against us based on those lies, even if you have invested hundreds of thousands of dollars of your hard-earned money in this phony business.” Wow.

Do you have that one in your franchise agreement? You might have to do a bit of hunting for it. You would think something like that would be on the first page, bolded, in caps, with a box around it and perhaps accompanied by a self-lighting sparkler that draws your attention directly to the provision when you open the contract. But no, in the case of the contract in which I found this provision, it was buried on page 36 of a 39-page franchise agreement, with no particular emphasis placed upon it.

I will never include a provision like this in a franchise agreement I draft, nor will I ever recommend that a prospective franchise buyer sign a contract when it includes this provision. Why? It's not only unfair, but it's also illegal under the Franchise Rule and under various state franchise laws.

The Problem with Having the Provision

Now, I highly doubt that in most situations, the franchisor even knows this provision is in its franchise agreement. Most start-up franchise companies trust their franchise counsel to draft the agreement and don’t necessarily carefully consider each provision in the contract. This sort of provision is typically created by counsel, who is seeking to protect his or her client. An admirable goal, to be sure.

05/26/2015

On May 14, 2015, the California state Assembly passed AB 525, a bill that would amend the existing California Franchise Relations Act (Business and Professions Code §§ 20000 – 20010) (“CFRA”) by expanding the protections for existing franchisees. As currently written, AB 525 would amend the CFRA in the following ways:

“Good Cause” Restricted to Substantial Compliance. Under the CFRA, a franchisor is permitted to terminate a franchise prior to the expiration of its term only for “good cause,” which includes (but is not limited to) the failure of a franchisee to comply with any lawful requirement of the franchise agreement after being given notice and an opportunity to cure the failure. Under AB 525, “good cause” would be limited to the failure of the franchisee to substantially comply with the franchise agreement.

60 Day Cure Period. AB 525 would create a mandatory period of at least 60 days for the franchisee to cure a material default under the franchise agreement, which cure period would apply in all but a few defined circumstances.

Right of Sale. A franchisor would be prohibited from withholding its consent to the sale of an existing franchise except where the buyer does not meet the franchisor’s standards for new franchisees.

Notification of Approval / Disapproval of Proposed Sale. A franchisor would be required to notify the requesting franchisee of its approval or disapproval of a contemplated sale of a franchise within 60 days of receiving from the franchisee certain mandated forms and information regarding the sale. If a franchisor does not provide its written approval or disapproval with the 60 day period, the sale will be deemed to have been approved.

Reinstatement or Purchase of Franchise. In the event that a franchisor either terminates or fails to allow the franchisee to renew or sell its franchise in violation of the CFRA, the franchisor would be required to, at the election of the franchisee, either: (a) reinstate the franchise and pay the franchisee damages; or (b) pay the franchisee the fair market value of the franchise and the franchise assets.

Monetization of Equity. A franchisee must have the opportunity to “monetize its equity” (obtain the fair market value of the franchise and its assets) prior to the franchise agreement being terminated or not renewed by the franchisor, except under certain limited circumstances.

03/17/2015

The top stories in the franchise world continue to be about efforts by the cities of Seattle, Chicago, and others in raising the minimum wage with laws that discriminate against small business owners who own franchises. For the full story, see some of my previous blog posts on the issue. These laws are a serious concern for franchisees and franchisors alike.

In brief, these laws (which are written substantially the same way in the different cities that have adopted them) require small businesses to raise the minimum wage of their workers from the current level to $15 an hour. Under these new ordinances, businesses with more than 500 employees have 3 to 4 years to increase the minimum wage to the new $15/hour level, while "small businesses," defined as businesses with fewer than 500 employees, have up to 7 years to reach the new level.

The problem? For the purpose of calculating the "500 employees" number, all franchises in the same system are counted together. The net result of this is that these locally-owned small businesses with a few employees, which also happen to be franchises, are being discriminated against as compared to their non-franchised counterparts.

After reading some of my blog posts on the subject, another franchise attorney (one who exclusively represents franchisees) commented to me that these laws, which treat franchises differently than similarly situated non-franchise small businesses, could arguably be viewed as "industry specific" laws for the purposes of Item 1 of a franchisor's Franchise Disclosure Document (FDD). I can see the argument on both sides of that point.

The Federal Trade Commission's (FTC) Franchise Rule requires a franchisor to state in Item 1 of its FDD "any laws or regulations specific to the industry in which the franchise business operates." The FTC has elaborated on this requirement by saying that laws applying to all businesses generally do not need to be disclosed; instead, "only laws that pertain solely and directly to the industry in which the franchised business is a part must be disclosed in Item 1."

The minimum wage laws adopted by some cities like Seattle target franchises by treating them differently from other similarly-situated small businesses; laws that are specific to a certain "industry" are the types of laws that need to be disclosed in Item 1.

So, the question then becomes: is franchising as a whole an "industry?" Are these the types of laws the FTC was contemplating when creating the Item 1 disclosure requirement? Should Item 1 of a franchisor's FDD should disclose these laws?

Mr. Griffin's view is that the standard that has long been applied by the NLRB to evaluate employment in the franchise relationship context is wrong because it does not focus heavily enough on the control that franchisors actually exert over franchisee employees in their day-to-day operations. Mr. Griffin believes that the level of control exerted by McDonald's over the employees of its franchisees is significant enough to change the character of the relationship, making McDonald's not only a franchisor, but also a "joint employer" of its franchisees' employees.

In particular, during the talk Mr. Griffin focused on the computer and software systems that McDonald's requires each of its franchisees to use. In this computer system, he says, McDonald's is able to monitor all activities at each franchise location on a minute-by-minute basis and uses this data to direct its franchisees when to schedule their employees for work, and when to send their employees home. This control, which Mr. Griffin says is direct control over employee hours, is enough to make McDonald's a "joint employer" of those employees.

Of course, the franchisor's view is that the direction given by McDonald's to its franchisees is only guidance, which is given to help the franchisee operate its business more efficiently.

The long term effect that General Counsel's decision, which sent shockwaves around the franchise industry, will have on franchising is still unknown, but his comments during the WVU talk do offer a glimmer of hope to franchisors that they can avoid "joint employer" liability by not having McDonald's level of involvement in day-to-day franchisee operations and employee scheduling.

As we move into 2015, most franchisors will be re-evaluating their franchise documents (including their Franchise Disclosure Documents and Franchise Agreements) as part of the annual update, registration, and renewal process. This is a good time to talk with counsel about ways that those documents can be amended to offer additional elements of protection against being found to be a "joint employer" of franchisees' employees.

If you want to discuss how you may be able to improve your franchise documents to respond to these and other new threats heading into 2015, please feel free to contact me.

07/30/2014

If you are a businessperson, sooner or later you will have to deal with a lawyer. In the franchise world, it helps – tremendously – to deal with attorneys who understand franchising and franchise law. It doesn’t matter whether you are a franchisor or a franchisee; no matter which side of the transaction you happen to be on, you will want an experienced franchise attorney to be on the other side.

Surprisingly, the level of franchise law knowledge among attorneys who actually get involved in franchise transactions varies considerably. The majority of the time, lawyers who are knowledgeable in franchise law are on both sides of the transaction. But that is not always the case. Sometimes, the attorney on the other side is inexperienced, and “dabbling,” in franchise law.

This article explores the problem of inexperienced counsel from the point of view of the franchisor, which is using an attorney that has little or no familiarity with franchise law (or, even worse, the company is using a consultant who is not a lawyer).

Why Franchisors sometimes use Inexperienced Legal Counsel

If a company is considering franchising its business (a “start-up” franchisor), one of the first things the company does is look for legal counsel. Finding an experienced franchise attorney is not a simple task; there are only a few hundred attorneys in the country that specialize in franchise law. A start-up franchisor may look to its local business attorney to help the company draft its franchise agreement and franchise disclosure document (“FDD”), and otherwise help the company comply with its legal obligations.

The business attorney may be tempted to do the work, instead of referring it to another lawyer. After all, form FDDs and franchise agreements are relatively easy to find, and many of them look similar to one another. But the problem is that franchise contracts and FDDs aren’t “one size fits all” legal documents, and the franchise relationship isn’t a typical business relationship. It is critical for attorneys who work in franchising to understand the documents they draft, the legal requirements for disclosure (both federal and state), and how the pieces of the documents need to fit together.

06/04/2014

As an attorney who represents franchisors, a significant part of my practice is drafting franchise agreements and franchise disclosure documents. Once these documents are completed, I also help franchisors comply with state laws by filing and maintaining their registrations in the various states that have franchise registration laws. As a result, much of my time (particularly during the first half of the year) is spent dealing with franchise regulators in various states.

During my years of practice, I have seen a number of common mistakes made by both start-up and established franchisors in their Franchise Disclosure Documents (“FDDs”). Many of these mistakes, which can cause delays in a franchisor’s ability to obtain registration, are easily avoided. Make them, and state regulators will refuse to register your franchise offering – sending you a comment letter requiring you to correct your errors before issuing a registration permit. Avoid them, and your time to obtaining registration may be cut down by weeks, or even months.

A common FDD mistake is failure to list all “Initial Fees” in Item 5. Item 5, entitled “Initial Fees,” is where a franchisor must disclose all initial fees paid by the franchisee, and the conditions under which the fees are refundable. “Initial Fees” are defined as “all fees and payments, or commitments to pay, for services or goods received from the franchisor or any affiliate before the franchisee’s business opens, whether payable in lump sum or installments.” A franchisor must also disclose whether the initial fees can be paid in installments, and what those payment terms are.

Many franchisors do not follow instructions and fail to list all initial fees in Item 5. These mistakes typically come in two varieties.

1. Common Mistake #1: Failure to List All Initial Fees Paid to the Franchisor

The first type of mistake is that the franchisor or its counsel assumes that “Initial Fees” means only the initial franchise fee paid by the franchisee (the fee franchisors charge franchisees for the right to enter into a franchise agreement). This is wrong because it ignores the other types of fees that are paid (or that the franchisee is committed to pay) to the franchisor prior to the franchisee’s business opening.

In some franchise systems, there can be a multitude of initial fees charged that need to be disclosed in Item 5. Some examples:

In connection with processing the franchisee’s application (running credit, doing a background check, etc.), the franchisor requires a deposit or “application fee.”

The franchisor charges a fee for the franchisee to attend initial training.

The franchisor requires (or has the right to require) the franchisee to pay a fixed amount directly to the franchisor so that the franchisor can conduct grand opening advertising for the franchisee.

The franchisor charges a technology start-up or other type of fee relating to the franchisee’s use of the franchisor’s point of sale or other software system.

This is only a partial list of the types of fees that can fall under the category of “initial fees.” I have seen many FDDs where franchisors will clearly charge these fees, but fail to list or disclose them in Item 5.

2. Common Mistake #2: Failure to List All Initial Fees Paid to the Franchisor’s Affiliates

The second type of common mistake is the franchisor lists only initial fees paid by the franchisee directly to the franchisor, but ignores the fees paid to the franchisor’s affiliates. The instructions for Item 5 clearly call for these fees to be disclosed, too. Remember, an “affiliate” is defined as “an entity controlled by, controlling, or under common control with, another entity.”

Some examples of fees paid to a franchisor’s affiliates:

The franchisee must purchase an initial stock of inventory from the franchisor’s affiliate.

The franchisor’s affiliate builds out the store for the franchisee (often referred to as a “turn key” franchise), and the franchisee pays the affiliate for the build-out.

The franchisee is required to pay the franchisor’s affiliate to buy or obtain the right to use the franchisor’s proprietary software system.

The franchisee buys an initial supply of marketing materials from the franchisor’s affiliate.

Again, these are just some examples of the types of fees that are paid to affiliates. If these fees are paid before the franchisee opens for business, they are “initial fees” and must be disclosed in Item 5.

Conclusion

Avoid making these common mistakes in Item 5 of your own FDD, and you will have an easier time of getting registered in the registration states.

05/27/2014

As an attorney who represents franchisors, a significant part of my practice is drafting franchise agreements and franchise disclosure documents. Once these documents are completed, I also help franchisors comply with state laws by filing and maintaining their registrations in the various states that have franchise registration laws. As a result, much of my time (particularly during the first half of the year) is spent dealing with franchise regulators in various states.

During my years of practice, I have seen a number of common mistakes made by both start-up and established franchisors in their Franchise Disclosure Documents (“FDDs”). Many of these mistakes, which can cause delays in a franchisor’s ability to obtain registration, are easily avoided. Make them, and state regulators will refuse to register your franchise offering – sending you a comment letter requiring you to correct your errors before issuing a registration permit. Avoid them, and your time to obtaining registration may be cut down by weeks, or even months.

The Disclosure Requirement

On the top of the list of these common FDD mistakes is the franchisor’s failure to comply with the requirements for Item 2. Item 2, entitled “Business Experience,” is where a franchisor must list employment history of certain of its key officers, managers, directors, and employees. The instruction for completing Item 2 is a simple one:

Disclose by name and position the franchisor’s directors, trustees, general partners, principal officers, and any other individuals who will have management responsibility relating to the sale or operation of franchises offered by this document. For each person listed in this section, state his or her principal positions and employers during the past five years, including each position’s starting date, ending date, and location.

That’s it – that is the entire instruction for Item 2. The instruction does not call for the franchisor to give the entire resume, or even a mini biography, for its key personnel. But that’s exactly what many franchisors tend to do.

Common Mistakes in Item 2

The franchisor’s natural tendency in Item 2 is to use it as a sales tool – explaining why and how its key people are well-qualified, outstanding individuals with a long history of leading successful companies, and why they are great human beings, to boot. Here’s an example of how a non-compliant, overly-descriptive Item 2 might look:

Jules Winnifield, President

Jules has been the President of Jack Rabbit Slim’s Franchising Company for six years, and has been the driving force behind growing our franchise system from two locations to seventy-five. Before coming to work for Jack Rabbit Slim’s, Jules was the Chief Operating Officer of Red Apple Security, one of the largest private security companies in the world. During his eight years at Red Apple, Jules was responsible for a 22% increase in revenue company-wide. Jules earned his Ph.D in Behavioral Psychology from the University of Santa Cruz in 1992. In addition to his hobbies, which include walking the earth and memorizing passages from important works of literature, Jules enjoys spending time with his wife, Mia, and his children, Marsellus and Lance.

So what’s wrong with the above description? A lot. First, it provides only a small portion of the information called for by the instructions in Item 2. While it does at least describe where Jules has been employed for the last five years, it doesn’t tell you the dates of employment or where those positions were located. Second, the listing reads like a sales pitch, telling the prospective franchisee why Jules is so well-qualified for his current position. Nothing in the instructions for Item 2 asks the franchisor to provide that information. Third, the franchisor has provided more than five years of work experience for Jules, going back more than thirteen years into Jules’s prior employment. Fourth, the Item 2 instructions do not call for educational experience – only work history. And in this situation, it’s not even clear that Jules’s doctoral degree is even relevant to his current line of business. Fifth, nothing in the guidelines asks a franchisor to provide information regarding the hobbies or family members of its key personnel.

You might think I’m exaggerating non-compliance with Item 2 when I list Jules’s hobbies, wife and children. I’m not. I’ve seen many franchisors provide exactly that type of information in Item 2 of their own FDDs.

How An Item 2 Disclosure Should Look

Here’s how an Item 2 disclosure should look:

Vincent Vega, Chief Executive Officer

Vincent has been our Chief Executive Officer since March 2012. Prior to becoming our CEO, Vincent was President of Butch’s Boxing Club in Inglewood, California, a position he held between December 2010 and March 2012. Before that, Vincent was the Vice President of Operations for McDonald’s in Amsterdam, the Kingdom of the Netherlands, a position that he held between October 2006 and December 2010.

The above Item 2 description is correct because it provides all of the information called for by the instructions, and only that information. Vincent’s work experience the location of each position he held is listed in the description, and his starting and ending dates with each employer (month and year are all that is necessary) are given. The disclosure gives enough information to cover his last five years of employment, and no more.

Conclusion

Avoid making these common mistakes in Item 2 of your own FDD, and you will have an easier time of getting registered in the registration states. While it may be tempting to include the extraneous information in Item 2, your doing so will increase the likelihood that you will obtain comment letters from those states, and that your registration will be delayed as a result.

Matthew Kreutzer is a Partner at Howard & Howard Attorneys and serves as Chair of the firm's Franchising, Distribution, and Antitrust Practice Group. Mr. Kreutzer, who is based in the firm's Las Vegas office, is a Certified Specialist in Franchise and Distribution Law by the State Bar of California's Board of Legal Specialization.

About This Blog

This blog is dedicated to advancing the franchising industry through the sharing of business, legal, and practical information and ideas. This blog is a service of Howard & Howard's Franchising, Distribution, and Antitrust Practice Group.